Improving And Modifying Your Narrative – The Feedback Loop
Once your narratives are ready and have been replaced with numbers in order to reach a value for the company, is the job done? Well, according to the professor, no. The work has just started. The reason being when you are telling a story, it is your own story and can definitely be misleading. Therefore, it is equally important to listen to other people’s stories about the same company or take others’ viewpoints on your story about the company in order to make the right decision.
The following are the methods suggested by Professor Damodaran in this chapter:
- Fighting Hubris: Once you have developed a story about a company, you naturally start feeling biased about it. You obviously won't support any criticism of it as per the normal human nature. However, it is disastrous in stock markets. One should tell their narrative about the company to a group of people who are not like minded and then analyze their view points to understand any misses or corrections required in your story.
- Face up to Uncertainty: Since the story is a prediction about the future, hence it does not make sense to aspire for preciseness. Following measures are suggested to overcome this problem of uncertainty: Create a scenario analysis wherein you are analyzing various scenarios affecting the company and subsequently the change in valuation due to those. This can be done with various statistical tools such as Monte Carlo analysis, decision trees, what if analysis, etc.
- Pricing Feedback: The steps we followed are, forming narratives, attaching numbers to those narratives and finally getting the value. Now comparing this value with the market price, we most probably will find it divergent from the market price. There are three obvious reasons for the same, the market is wrong and you are right, market is right and you are wrong and the third being, both are wrong and intrinsic value is an unknown number. The best way to have an unbiased opinion as per Professor is to recognize the differential as due to the third reason. With that, you now need to reverse engineer the market’s expectation about the company’s fundamentals given the current price. This allows you to get feedback of how your expectation about the company differs from the market and hence change the narrative if required.
Finally, in order to get proper feedback, follow these suggestions by the Professor:
- Make your narrative and valuation transparent
- Have an open forum for people to comment on your valuation
- Separate constructive criticism from noise
- Use the narrative to organize the criticism
- Look for the weakest link
- Think process, not the product, i.e., focus more on the forecasts then on the value derived.